Value Investing Strategies of Warren Buffett and Benjamin Graham

Archive for December, 2006

I have not written anything for the past few days as I was not able to connect to blogger.

A few days ago, there was an earthquake in Taiwan that destroyed major communication cables deployed under the sea. As a result, the internet access in my country was badly affected.

Hardly anyone was able to connect to websites that were overseas, and many businesses had their operations disrupted.

It will take a few weeks for services to be restored to normal.

For now, my internet is crawling along at a very slow speed, just like pre-broadband times.

As we move forward in the internet age, we seem to take for granted the availability of information at our fingertips. We forget that many factors beyond our control could and will alter the environment that we operate in.

Is your investment portfolio ready for such shocks or changes? Rather, does the businesses that you invest in have such a strong moat that such shocks will not bring them down?

In my previous post, I talked about the difference between a franchise and a business.

Buffett is of the view that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior.

This is because of the changes in retailing pattern and also an significant increase in other entertainment and advertising choices.

Previously, media properties possessed the three characteristics of a franchise and therefore could both price aggressively and be managed loosely.

Nowadays, consumers looking for information and entertainment have so many choices and the supply is simply much more than demand.

The result is that competition has intensified, markets have fragmented, and the media industry has lost some – though far from all – of its franchise strength.

In light of this phenomenal, let us look at the impact on the value of media properties.

In the past, a newspaper, television or magazine property would forever increase its earnings at 6% or so annually. This would be done without additional capital, as depreciation charges would roughly match capital expenditures and working capital requirements would be minor.

Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings. This meant that ownership of a media property is like owning a perpetual annuity set to grow at 6% a year.

Using a discount rate of 10% to determine the present value of that earnings stream, one could then calculate that it was appropriate to pay $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)

Back to the present, assume that this $1 million represents “normal earning power” and that earnings will stay around this level instead.

This is true of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings).

Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. A modest shift in assumptions reduces the property’s valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).

This simple example shows that valuations can change dramatically when there is just a minor change in expectations!

Warren Buffett mentions that an economic franchise arises from a product or service that:

(1) Is needed or desired;
(2) Is thought by its customers to have no close substitute; and
(3) Is not subject to price regulation.

If all three conditions are present, the company will be able to increase its prices regularly and earn higher rates of return on capital. This can be achieved even without requiring additional capital.

A franchise is also more tolerant of inept management. They can reduce the franchise’s profitablity, but they are unlikely to kill the franchise.

For a business, Buffett is of the opinion that it will be able to earn exceptional profits only if it is a low-cost operator or if supply of its product or service is tight.

And in the real world, tightness in supply usually does not last long.

If management is good, a company might be able to keep costs low for a much longer time, but they will always face the possibility of a competitive attack.

And unlike a franchise, poor management can kill a business.

Based on these reasons, a franchise and a business should be valued differently.

(1) the reported operating earnings, plus ;
(2) the retained operating earnings of major investees that, under GAAP accounting, are not reflected in the profits, minus;
(3) an allowance for the tax that would be paid if these retained earnings of investees had instead been distributed.

Investors can also benefit by focusing on their own look-through earnings. This can be calculated by looking at the total underlying earnings attributable to the shares that you hold in your portfolio.

Your role should then be to create a portfolio (or “company”) that will produce the highest look through earnings a long time from now.

Using this approach will force you to look at the long term business prospects rather than the short term market movements. Future earnings will, at the end of the day, influence the prices.

“In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.”

Warren Buffett values convertible stocks by looking at three things: interest rates, credit quality and prices (or more precisely, valuation) of the related common stocks.

He warns against inaccurate or misleading valuations by others. For example, several members of the press calculated the value of all their preferreds as equal to that of the common stock into which they are convertible.

By their logic, Warren’s Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80.

The problem with using this valuation is that all of the value of a convertible preferred would reside in the conversion privilege and that the value of a non-convertible preferred would be zero, no matter what its coupon or terms for redemption.

This does not make any sense at all.

The correct way of valuing convertible stocks is to firstly look at their fixed-income characteristics. Then, you look at the conversion option and see whether it adds additional value to the basic fixed income valuation.

What this means is that the securities cannot be worth less than the value they would possess as non-convertible preferreds.

What happens if Warren Buffett Dies?

Warren candidly mentions three things that would happen if he passes away suddenly:

“(1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire’s earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).”